Question

An oil company consisted of two divisions, on involved in the production and sale of natural gas products and one involved in petrochemical production. The former division owned and operated about ten plants containing extraction units, which took the gas liquids out of the natural gas stream, and fractionators, which separated the gas liquid stream into particular gas liquids. The latter division, which had a variety of petrochemical plants, bought about half of the ethane it used from the former division. The price that the gas products division charged the petrochemical division for ethane was determined by formula that was designed to help the gas products division earn a 12 percent rate of return on its own investment. This formula evolved from negotiations between the former heads of the two divisions, but the present head of the gas products division felt that is should be abandoned because he could get much more for this ethane by selling it to buyers outside the firm. (The formula resulted in a price that was below the current market price of ethane.) On the other hand, the head of the petrochemical division pointed out that the ethane production facilities at the gas products division had been constructed to provide ethane for his division. If you were a consultant to this firm, would you support the recommendation of the head of the gas products division? Research a bit about transfer pricing models, and explain why or why not? Include references.

Answer 1

As the consultant of the firm, after analyzing the situation that the Gas Product Division and the Petrochemical division of the Company is going through I would not support the recommendation forwarded by the head of the gas products division. There are various reasons not supporting such a recommendation which seems profitable for the Gas product division. Firstly, both the units operating in the company is owned by a single organization and if the Gas product division is selling the Ethane to a different organization outside then it is clear that the Gas Product division will create more profit than what it is currently making, but the Petrochemical unit will have to purchase the ethane required for their functioning from a different organization and they will charge more. So, this will actually not help because as a whole the organization may not any significant profit.

Such a recommendation will create a rift in the organization because till date the units have a healthy relation among them which is expected and again they both are working to achieve the same goal and objective which is earning profit for the company. The head of the plants will think about the individual profit of their plants more because even their performance is monitored, but in order to do so the organization cannot disrupt the relational hygiene that the organization possess. Transfer Pricing is another concept which is very much important in this context because Transfer Pricing generally refers to the rules and processes for fixing transactions that occurs within the same business. If transaction between two entity is taking place and both the entity is under the same organization, then the pricing is different and generally less in comparison with the transactions among different organizations.

Transactions and business in the same organization is profitable because the tax paid will be low because there is no point of distorted taxable income in this context. As the consultant of the organization I would like to continue with the same setup because after the analysis it is very much clear that the interest of the company as a whole can be served with the existing process. In order to make things a bit more fair instead of the 12% rate of return it can be increased to some extent so that both the Unit Head get fair share.